ONE of the most basic principles in economics is that the taxation of capital income is inefficient. Taxes on interest, dividends, and capital gains represent a sort of “double taxation”, of wage income. For some reason many people have difficulty grasping this concept, and one often sees even Nobel Prize-winning economists talking about “income inequality” using data that includes both wage and capital income. This makes about as much sense as adding up blueberries and watermelons and calling it the “number of units of fruit”.

To see why this is so, consider twin brothers who each make $100,000 in wage income. Most people would regard these two people as equally well off, even if one freely chose to consume his income now, while the other chose to consume later. But not advocates of the income tax. They insist the more patient twin brother is “richer” and deserves to be taxed at a higher income tax rate. For instance, compare a 40% wage tax with a 40% income tax. Under the wage tax (sometimes called a “payroll tax”) the spendthrift brother is able to consume $60,000, which is 40% less than in a no-tax economy. Now assume the thrifty brother invests the after-tax wage income for 20 years, and sees the money double to $120,000. Then he can consume $120,000 20 years in the future, which is also 40% less than the no- tax consumption level. This sort of tax is neutral with respect to saving and investment; it's essentially a flat rate tax on consumption, whenever it occurs.

But that's not good enough for proponents of taxation of capital income. They want the thrifty brother to pay a 40% income tax on the $60,000 in capital income, leaving him with only a net gain of $36,000. Now the thrifty brother can only consume $96,000 in 20 years, thus he essentially paid a 52% tax on his consumption (as he would have consumed $200,000 in a no-tax scenario). The mistake people make is forgetting that the present value of $120,000 worth of consumption 20 years in the future is the same as $60,000 today. And in a sense that should be obvious, as both brothers are free to spend their money when they choose in the no-tax situation, so obviously the thrifty brother would not be economically “better off” merely because he chose a different year to consume his income. Both are equally “wealthy”, where wealth is the present value of lifetime consumption.

A common misconception is that a wage tax would favor the rich, who tend to save more than the poor. But this is confusing two completely separate issues; the total resources someone has to utilise during their lifetime (or their heir's lifetime) and the preference people have for current consumption versus future consumption. Because of the declining marginal utility of consumption, there is a very strong argument for making wage taxes progressive. Indeed there is no technical limit to the progressivity of wage taxes. But there are no good arguments for taxing capital income.

Of course there are practical problems with any tax regime. People will try to shield wage income by calling it “capital income”. To prevent this all income earned by corporate employees as part of their job should be treated as wage income, including earnings on their firm's stock and options. Likewise, those who work for financial firms such as hedge funds should pay wage tax on any and all income received that is in any way associated with their employment. All income to the self-employed should be treated as wage income, and investments in capital goods can be expensed.

Even with every possible safeguard, there might be some wealthy people who are clever enough to avoid taxation. If this were a serious problem, we could have a wealth tax on luxury consumption (mansions, yachts, private jets and other luxury goods). Another potential problem is that some wage income actually represents the return on investments in human capital. Thus a progressive wage tax discourages the accumulation of human capital. In practice, however, this is mitigated by the large public subsidies that are provided for education.

To conclude, the optimal income tax is a simple payroll tax, similar to America's FICA tax. This would eliminate the need for most people to fill out any tax forms, which would be an enormous efficiency gain even apart from benefits from eliminating the double taxation of the portion of wage income that is saved. The payroll tax should be progressive, and indeed should be negative for adults over 21 years old (or anyone with children) that are paid low hourly wage rates.

There should be no corporate income taxes, which represent triple taxation of wage income. If the current distribution of wealth is deemed unjust, then there should be a one-time wealth tax at the point of transition to the new tax regime, to be paid over a period of several years.

Mr. Sumner makes the argument that capital gains is an example of double taxation, and does it quite well, but does not touch on other examples of double taxation.
While it is possible to deduct for some business expenses using a personal corporation or other means, many business expenses paid for personally (commuting, mobile phone, laptop, etc) are not deducted by the vast majority of working people.
The problem is that these expenses often act as personal investments, increasing wages over time. While personal laptops used to supplement outdated hardware from an employer is one of the best examples of this, the reality for many workers is that 'personal' expenses are used to either increase their productivity or allow them to gain experience over time (no commute, no promotion).
These personal investments are taxed doubly just like investments in financial products, but under the income tax instead of capital gains. This results in huge inequalities. What is the difference between an oil worker driving to find work in North Dakota and a person buying equities? Both have large payouts, but they are taxed differently. The payout of moving expenses for the oil worker will be taxed under income tax, while the payout for the equity owner will be taxed under capital gains.
While the oil worker will likely pay at a lower rate than the equity owner on their payout, it can be possible for the situation to be reversed. What about subscribing to an industry magazine? Small cost, possibly huge payout for some, taxed under income tax.
I believe it should be acknowledged that financial instruments are only one type of investment, and that it would be prohibitively complicated and expensive to work out all the categorization to avoid double taxation in all types of investment. Therefore, to avoid favoring one type of investment over another, income from all sources, including capital gains, should be taxed under the same system, whatever that may be.

Capital income should be split into two parts. The first one is a compensation for inflation. It should not be taxed as it does not bring any real enrichment to the capital owner. But the argument does not apply to the inflation-free income.

Besides, the point does not work well with inherited capital as individuals rather than families are liable to taxes.

I think this is the right idea, except that I would use the risk-free rate of return instead of the inflation rate.
It doesn't take any effort to realize the risk-free rate of return (by definition). Returns above that level require work; the extra return isn't just the time value of money, but a reward for doing that work.
The T-bill rate is a pretty good estimator of the risk-free rate of return. I would even be willing to be generous and add a couple of percent to it, if that would allow us to agree that gains beyond that should be taxed as ordinary income.
Oh, and I agree with the author that there should be no corporate income tax.

Firstly, another way to avoid double-taxation is to allow wage-earners who wisely invest their incomes to deduct wage-taxes paid against any investment income earned. To argue that avoiding double taxation means taxing wage-income and exempting business income seems self-serving.
Secondly, business capital does not ONLY come from wage earnings. A large part of it comes from redeployment of corporate profits, capital gains and interest earnings, none of which would be taxed under the author's proposal. Capital also comes from overseas investors who would have paid zero US-taxes on their earnings. If you say that ALL business capital (even redeployed corporate profits) ultimately comes from wage income, then even wages are ultimately being paid from that very pre-taxed business profit, so basically there should be not tax whatsoever. Not a practical position to take.
Thirdly, the line between labour earnings and capital earnings is not so clear as the author makes out.
EXAMPLE 1: Say I'm a full-time full-time investor making an average annual investment income of USD 1,00,000 a year out of my investing activity. There are two ways to see this:
i. Since the original seed capital came from wage earnings, it was already taxed and further earnings from it should be tax-free.
ii. Investing is a form of labour and the income from it is a kind of wage - therefore it *should* be taxed. (investing losses of course being offset-able)
EXAMPLE 2: Instead of being employed as an accountant or a truck-driver I can incorporate a business to hire out accounting or truck-driving services to my (former) employer. My business charges a "fee" (similar to my previous salary), earns a profit and pays it out to me as dividends. Neither the profits nor dividends are taxed. Earning wages is for suckers!
My point is that the dividing line between labour and business income is NOT so clear cut.
Here's another solution:
i. Reduce taxes on corporate income to zero / near-zero levels
ii. Tax income from interest, dividends and *realized* capital gains @ the same progressive-rates as wage income (maybe a notch lower to encourage savings & investments)
iii. Since corp tax is zero, there is no "triple" taxation. You also remove any incentive for corporations to indulge in loophole creation and fancy accounting to reduce taxable profits

Exactly! After all, if the second brother puts his savings under his mattress, he wouldn't pay a cent in taxes from investment income. It still wouldn't change the fact that he pays a higher tax as percentage of consumption than his brother does. As long as the second brother values a rainy-day fund over immediate consumption, his present values are perfectly balanced.

The other brother would logically not lend or invest unless he's getting enough post-tax returns to justify both the risk and the delayed consumption. The fact that he is choosing to invest automatically means that he's getting a sufficient post-tax return on investment to even things out.

In such a scenario, if you remove taxes on investment, the long-run effect will be to reduce the rate at which he lends / invests his money (and vice-versa).

as a uk citizen, with the average in real terms taxation on individuals being around 70%, I would be seeking a solution to taxation that will simply tax each citizen as little as possible to provide some very basic services of health and education, and not tax more if you are more successful.
The UK system takes my money and re distributes it to my relatives who do not want to work. In a different world, I could say "hey, I'll help you out, but you have to do something for the help", but in this world, my money is taken and given to my relative with five illegitimate children (just one example) to keep her and them in better conditions than my children had when they were children (e.g. the state provides them with a four bedroomed house, money for sky tv, good disposable income etc.!). Money is squandered on free computers given to all children of unemployed people and free school meals (which they wouldn't need if their mother would get out of bed and cook good food) while people working on low wages go without and even the better off can't possibly provide for themselves in their old age, no matter how thrifty they are!

To spur the economy people have to spend money. The capital gains issue is a matter of degree. Someone living paycheck to paycheck living on his wages and saving some for a rainy day should not be the target of increased capital gains taxation. Someone who lives off his capital gains investmests and draws his living wages from those investments should pay a progress tax rate in line with the income tax rate.

Money tied up in investments with gains continually re-invested create an economy that is subject to the whims of a relatively few investors. There is a limit to the utility of invested wealth in a down economy that is inversely proportional to the size of the pool of investors under the estimated wealth of the total investments.

While fairness and the net benefit to current investors call the efficacy of capital gains taxation into question, I believe there are even more pressing arguments against it that have been neglected in this discussion.

From a macro perspective, consider the inefficient allocation of resources. From real estate to stocks, investors are inherently discouraged from efficiently placing their investments where they most desire because of CGT. This leads to over-investment in toxic areas and under-investment lucrative industries. The tax, moreover, inhibits investment by the risk-adverse since a greater gain must be expected on each investment in order to offset the the forgone income.

Additionally, by creating a disincentive to invest, the nation's marginal propensity to save will fall; less saving then leads to stunted economic growth in the future.

If you are concerned about the inequality between income classes, then eliminating the capital gains tax is a step in the right direction. Increased investment raises national productivity and bolsters income across the board (yes, even if it is disproportionate). Raising the middle class income would lead to more investors thereby inducing a multiplier effect. With the presence of the CGT, the process is reversed and replaced with a cycle of redistributive failure.

Capital gains taxes are also one of the main reasons for people holding onto assets they would prefer to sell. For example, in the UK, 1000s of houses sit empty or underutilised simply because the person owning them faces a large cgt bill if they sell. And then what do you invest in - you can no longer afford to buy a house in the same bracket as what you just sold because of the illusory profit you made. Same goes for shares.

Isn't the problem that you have people who are not investing their wage income, but rather investing their capital gains over and over — gains that would be impossible to obtain or secure without a functioning government? In a situation in which tax on capital is 0%, those who benefit from the presence of a state in order to protect their capital and create pre-conditions for the market pay very, very little tax indeed. That hardly seems fair either.

I make a small middle class income but still I have always saved. I've been saving 20% of my income for the past 25 years. Today I am earning 0.5% interest with 3% inflation....which yields me a negative 2.5% real return. Yet even as I lose money (measured in real terms) these left wing progressive radical democrat liberals want me to pay tax on my negative return. It's just not worth it. If you are young my recommendation: don't save, don't invest, live paycheck to paycheck, rack up as much debt as you can and then every 7 years have the debt discharged in bankruptcy court. Otherwise the progressives will punish you.

I have to say after reading the comments in this section I still agree with the most part with the author. It sounds like a great idea to tax any income including capital gains but the reality of the situation is that would discourage investment. I don't know how many of you have investments but why even bother trying to make a return investing when you have to deal with issues of inflation and a tax on top of that. This could really add up over years. Lets say you make an initial investment of 10,000. Inflation is at 6% per year over the life of a 20 year investment. Your rate of return is 8%. So you make $46,609.57 Sounds good but the worth of $10,000 in 20 years is $32,071.36 so you really made 14,538.21. lets say capital gains tax is 20%? Better take that $9321.91 out. Congrats you made $5,216.29 over 20 years. But wait that's the future value of your money. Let's see how much its worth today... $1626.46. Less than a 1% return on investment in actual dollars. Why invest?

Money not spent must be taxed as long as that money create income (dividends, interests and what so ever). How you can tax the wealthy (never thrifty) people who has billion dollors of the saving account at banks and never work for their living? If we say your lovely thrifty brother earn money only from money, he is already living at no tax world without the capital income tax.

And this is why it's best to ignore the basic principles of economics and just use common sense. If the person does it for a living, if in the person doing it they eat up government resources (thereby costing the government money), if it makes money, tax it. I don't care how BS of an argument you can get paid to come up with. I understand that's the job of an economist, but it just more reason to ignore people like you.

In the example given, the present value of consumption deferred 20 years is identical to the value of consumption today. I understand that to mean his investment earned a rate of return identical to the rate of inflation. But what if the investment returned more? Should we not tax real returns on investments even if we agree that price appreciation due soley to inflation should not be taxed?

It seems a better approach would be to repeal all corporate taxes, index capital gains to inflation, and treat all investment income as ordinary income.

I've seen the complaint of "double taxation" a lot, and I think what it seeks to overlook is the fact that (to quote Mr. Romney) corporations are people, my friend.

Investment income is, in effect, the business getting paid and then the business paying you. If I work at Blockbuster and someone rents a movie from me for $10, then I buy some fast food on the way home and hand the clerk that same $10, did the $10 get "double taxed" because it changed hands twice? No. Because it went to two distinctly different entities.

Likewise, when a corporation is taxed on its gains and then pays its investors who are in turn taxed on their gains, this is the same functional series of events with the caveat that the investor most likely performed the labor of investing long before he saw a return.

What Mr. Sumner seems inclined to neglect is the time value of money. Namely, that there's very little difference between investors and wage earners at the end of the day. Both do labor. Both earn money. Perhaps they operate on different pay scales (the investor effectively operates on commission). Given Sumner's "thrifty brother / spendy brother" example, the thrifty brother has taken a part time job in which he is earning an extra $60k over 20 years. If the spendy brother instead spent time, say, earning a new degree or certification and increased his salary by $60k over the same 20 years, that $60k would still be considered wages and still be taxed. Why then are we rewarding investor brother and punishing education brother?

Earned income is earned income. Trying to attach morals or some sense of fairness to how that income is earned is silly.

It's not that the rate of return equals inflation. It is that the total gross proceeds under a no tax situation is 200k while under the income tax scenario, the net proceeds are 96k. Time value of money means that the longer the period and the higher the rate of return is, the greater the gap will be between net and gross proceeds under an income tax. The 200/96 example works under any combination of rates and periods where you can double your money through a capital gain.

If one could triple money though capital gains, the net after tax proceeds would be 132k over 300k gross proceeds for a 56% tax rate. That being said, I am not sure that an appeal to mathematical fairness does much to make a case for tax policy. I also think that if the use of money to make money was a tax free excersice, abuse would rampant.

This is also a tax bias against returned earnings - why reinvest profits in your own company and pay the full rate of taxes when you can make a passive investment that will generate tax free income. It also does not address the political issue of allowing pools of capital to accumulate tax free in the hands of selected individual and family groups. Luxury tax does nothing on the question of economic power.

it should be none of your business how much money someone else is able to make, or how little work they have to do that. The reality is that those people paying the most tax (even if it seems a small percentage to you) are funding your excessive life style even if they don't want to. We are all paying taxes for things we don't agree with, with no way of registering our dissaproval e.g. I don't like paying tax to keep my unemployed relatives in a v.good lifestyle and I am not allowed to complain that its unfair without being labelled uncaring! I also don't like funding silly schemes e.g. free doggy poop bags for dog owners because some people don't like the sight of sh*t!

I don't care how rich someone is, or how little effort it may be perceived they put into life, its none of my business - they are just fortunate - get over it.
What I do mind is many many people having their life destroyed because the state gives too many handouts - people see it as un economical to start on the work ladder, time passes, they have no life other than that of charity and never experience being independent and being able to provide for themselves and their families.

"Taxes on interest, dividends, and capital gains represent a sort of 'double taxation,' of wage income."

I'm surprised anybody has the nerve to make this argument give the "carried interest" situation, in which wealth is NEVER taxed as ordinary income. And the attempts to repeal the estate tax, which is a tax on money that wasn't earned to begin with.

To me, the scam and the estate tax repeal have devasted this argument. You can call for loophole fixing all you want, but the argument no longer has moral strength.

A case can be made that taxation of dividends and capital gains can be considered double taxation since the corporation paid taxes on its earnings and the ostensible owners are taxes again when they receive dividends out of undistributed profits or are taxed again when the shareholder sells the shares. Interest is deducted in dtermining net income so that taxation of interest is not double taxation.

"A case can be made that taxation of dividends and capital gains can be considered double taxation since the corporation paid taxes..."
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Obviously! That's the reason why dividends are not taxed are certain places and times and why capital gains taxes are generally lower than regular income. Still, double taxation, but less offensively so.

BTW, corporate tax rates are often as high as the highest tax bracket for people, which means that many savers are not only being double taxed but also at a higher rate than at other forms of income.

"A case can be made that taxation of dividends and capital gains can be considered double taxation since the corporation paid taxes..."
As a matter of fact, there is no reason to consider that only dividends do support that tax rather than salaries or interests paid to lenders. A corporation makes money, the basis for its taxation, from a combination of factors : capital, work and loans. One should ask the question : which stakeholder would benefit from a cut in the corporate tax ? The answer depends on the balance between the different stakeholders.
The same applies of course to other corporate taxes whether based on turn over or on salaries.

About our guest

Scott Sumner has taught economics at Bentley University for the past 28 years. He earned a BA in economics at Wisconsin and a PhD at Chicago. His research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. He had just begun research on the relationship between cultural values and neoliberal reforms, when he got pulled back into monetary economics by the current crisis.